April 23, 2008

Oil Hits $120...How High Will It Go?

One thing that has certainly affected my personal economy as of late has been the increasing cost on my budget for filling up with a tank of gas. More money spent on gas means I have less money for everything else because my income is a fixed and I'm subject to the budget-contstraint curve.

Yesterday I filled up at the Albertsons on Research Parkway (the same gas station that recently sold the $600,000 Powerball ticket) and was instantly out $60. I COULD have bought 60 Powerball tickets!

By buying gas, the friend I was with said that I should be proud of myself because I'm pumping money into the economy especially in our current market condition and then went onto explain how a car is a necessity and paying for gas is just "one of the things we have to do."

Well, I went home and thought about this a little more. Economics 101 says that an increase in price corresponds to decreased demand. But if my friend is correct and a car is indeed a necessity, then the car is a necessity because you're using it to accomplish pertinent day-to-day activities like going to and from work (You need to make money to live, right?).

Therefore, an increase in the price at the pump won't decrease the amount of miles driven because the number of miles you drive is fixed (sure, you might not go to the mall on the weekends anymore and might cancel that summer road trip). But you will drive to places you MUST drive to.

So the point of this posting is to point out that this "law" of economics which says that an increase in price leads to a decrease in quantity demanded may not be entirely true.

And this is certainly the case with inelastic goods such as gasoline! Am I right or am I right?


Roman Kozhevnikov said...

I agree with you. Although there might be a trend toward buying smaller, more fuel-efficient cars, which would decrease demand if the miles driven remains the same, this decrease has no effect on the amount of gas I demand.

I cannot afford to buy a smaller car or a hybrid car, but I must drive to and from work and to and from school. Unless gas goes up to like $10/gallon, my demand will remain fixed. If gas does go up that high, I will quit my job, because I would spend more getting to work than I would actually earn being at work.

So, as you said, an increase in gas prices does not effect the demand for gas as those pretty little diagrams and charts would suggest.

Roman Kozhevnikov said...
This comment has been removed by the author.
Douglas Loeper said...

The first thing I'd think of here isn't that the demand isn't decreasing with pricing but that either A) the price is below the equilibrium point and/or B) the demand doesn't decrease evenly across the board. As Roman mentioned unless gass went up to $10/gallon his demand will remain fixed. Well there you go, that's his equilibrium point, for him, also keep in mind that the S/D models are for the entire market not the individual. So where as his Eprice is $10 someone with less of a need for gas might be $2, most people, but not everyone is fully dependent upon petroleum. When gas hits $5 per gallon people might start figuring out the best way to use the bus and so on, or make less trips out, right now families aren't planning on making as many road trips during this summer as in previous years, and so on (flights etc). So I think it's more then just the price at the pumps. And if gas pricing hit $20/Gallon I might have to switch my job as it entails driving 3k miles a month.

Just some food for thought.

Tim Canon said...

I agree! Uh, sort of. Q Demanded of gas is not at all sensitive to prices, at least in the short run. In the long run, people will adjust, using carpooling, moving closer to work, and so on. I'm also willing to bet, though, that some of those previously "inefficient" alternative methods might all of a sudden become efficient in the face of such high oil prices. And I also bet that the people developing these methods are the people who are the very bane of our society, the global warmers, those evil schemers at the top who want to make money (imagine that): The OIL COMPANIES!

We will adjust in the face of such high prices. It'll just be as long as it takes to develop new methods (or for prices to decrease again-a possibility).

So in the long run, sir, you are not right. No indeed.

Larry Eubanks said...

I'm with Tim on this issue.

The question raised is really what the price elasticity of demand might be. The idea of perfectly price inelastic is a useful concept, but it is also a useful fiction from an economic perspective.

Whether the price elasticity of demand for gasoline is inelastic or elastic is an empirical question.

I can say that the last time gasoline prices were as high as they are today, in real terms, was around the 1979-1981 time period (or so). Economists have estimated price elasticities for gasoline for that period and the findings were that in the relatively short run demand was mildly price elastic, not even mildly price inelastic. And, of course, as Tim's comment suggests, over a longer time period demand was price elastic.

Will that be the price response today? I don't know, that is an empirical question. But, I'm pretty confident in predicting (both on past experience and conceptual considerations) that the market demand for gasoline is not perfectly price inelastic.